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Mutual Funds Oppose S.E.C.’s Plan for a Bigger Cash Cushion

Mary Jo White, chairwoman of the Securities and Exchange Commission, testifying before the House Financial Services committee on the budget on Capitol Hill last March.Credit
Gabriella Demczuk for The New York Times

The official, David W. Grim, was highlighting an initiative that would require mutual funds to increase their liquidity cushions to accommodate investors looking to leave in a hurry.

But the two industry representatives sitting on his panel — both of whom had held the fund watchdog job before he did — immediately went after him, arguing that the proposal was misguided and overly restrictive.

Hold on a minute, said Mr. Grim, a 20-year S.E.C. veteran whose gaunt appearance was accentuated that day by a cold that had left his voice scratchy and weak.

The agency is moving closer to putting the finishing touches on a new set of rules that would require mutual funds to not only set aside a larger share of easy-to-sell securities but also disclose in detail how quickly they can dispose of all that they own. And the fund management industry is pushing back — hard.

It has been close to 20 years since the S.E.C. last addressed the critical issue of how much of a fund’s assets should be invested in hard-to-sell securities. And during that period, the proportion of funds that invest in high-yielding assets like emerging markets and corporate bonds has increased sharply.

According to data from a recent S.E.C. paper, these types of funds accounted for 37 percent of the $12.6 trillion fund sector in 2014, compared with 16 percent in 2000.

To a certain degree, this push by the agency to require funds to be more liquid and disclose the riskiness of their investments mirrors the regulatory demands that commercial and investment banks face in terms of higher capital requirements and restrictions on trading activities.

And bodies like the International Monetary Fund, the Bank of England and the United States Treasury have been warning about the increasing risks taken by mutual funds as they pursue higher yields in a world of rock-bottom interest rates.

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“As banks become more regulated, there is a risk that the frailties of banking are replicated elsewhere — such as mutual funds with short-term or runnable liabilities investing in opaque credit instruments,” said Paul Tucker, chairman of the Systemic Risk Council and the former deputy governor of the Bank of England, who wrote one of the few comment letters endorsing the proposal. “When this kind of thing goes wrong the social costs are very high, so we hope very much that the S.E.C. does not retreat on this.”

Mutual fund companies and their defenders have taken up arms in numerous ways. They are challenging S.E.C. officials in public forums like last week’s industry gathering in New York (sponsored by the Practising Law Institute) and a larger conference next week put on by the Investment Company Institute, the main lobbyist for the industry.

They have posted a stream of comment papers on the S.E.C.’s website, explaining why these proposals would do more harm than good. And they have pressed their case in person, meeting at least 15 times with agency staff since last fall, according to regulatory filings.

The essence of the industry’s complaint is that the idea of segregating securities in a portfolio on the basis of how many days it would take to sell them is a fool’s errand. Liquidity, or finding a buyer for what you want to sell, is one of Wall Street’s foggiest and most subjective notions. To guess how many days it would take to sell a leveraged loan or a corporate bond from Brazil is next to impossible, experts argue.

“We agree that it is time to modernize the regulation of mutual funds,” said Barbara G. Novick, a vice chairwoman at the $4.6 trillion fund giant BlackRock who oversees its government relations activities. “But there are better ways to do this.” In BlackRock’s comment letter to the S.E.C., the firm recommended classifying securities by tiers of liquidity as opposed to the exact number of days it would take to sell each one.

Mary Jo White, the S.E.C. chairwoman, has said that the issue of fund liquidity is a priority for the commission in 2016. And while the agency’s staff is expected to submit a revised proposal to the commission this year, it is unclear how the S.E.C. will respond to the criticisms.

Joining the outcry are three of Mr. Grim’s predecessors at the S.E.C.’s investment management division who are now advocates for the industry.

One of those advocates, Barry P. Barbash, represents fund companies at the law firm Willkie Farr & Gallagher, and another, Paul F. Roye, wrote the comment letter in opposition to the S.E.C. rules for Capital Research and Management, a large asset manager based in Los Angeles.

Mr. Barbash and Mr. Roye were the ones who criticized Mr. Grim’s proposals on the conference panel last week. Norm Champ, Mr. Grim’s immediate predecessor, attended as a newly minted partner focusing on regulatory matters in the fund industry for the law firm Kirkland & Ellis.

Mr. Grim, 46, is by comparison an anomaly. He has worked in the commission’s investment management division for his entire career, forgoing lucrative pit stops in the private sector.

Mr. Grim is a furious advocate of the investor’s right to cash out of a mutual fund. He recites a simple maxim when explaining why fund companies need a tighter leash: It is the investors’ money, and if they want it back, they should be able to get it back.

The Third Avenue debacle had a particular resonance for him. Just three months after he outlined his proposal that funds revamp their cash management practices, a fund slammed the door on its investors because it had misjudged its ability to unload hard-to-sell investments.

“We have to do better,” Mr. Grim said at the conference, making the case that mutual funds promising instant liquidity must not get bogged down with impossible-to-sell securities. “That is the big lesson for me in terms of what happened at Third Avenue.”

A version of this article appears in print on March 10, 2016, on Page B1 of the New York edition with the headline: Funds Resist S.E.C. Plan to Pump Up Risk Buffer. Order Reprints|Today's Paper|Subscribe